3.Chapter 4 Ratio Analysis Liquidity Ratios, Assignment # 3 with answers

Chapter 4

Ratio Analysis

Learning Objectives:
The study material of this class would enable you to understand:
* Working of the first type of the Accounting Ratios :
* Liquidity ratios : Current ratio and Liquid ratio

               Task .

                Do Assignment # 3

Ques 1.

O& M limited has a current ratio of 3.5:1 and liquid ratio of 2:1. If the excess of current assets over quick assets as represented by inventory is 150000. Calculate current assets and current liabilities.

Ans. CA 350000, CL 100000

Ques 2.

A business has current ratio of 3:1, working capital 400000 ,opening inventory 100000 ,closing inventory 200000 ,prepaid expenses 30,000, accrued income 15000, advance tax 5000. Calculate the liquid ratio.

Ans. 1.75:1

Ques 3.

The ratio of current assets (450000) to current liabilities( 300000) is 1.5:1. The accountant of the company is interested in maintaining the ideal current ratio of 2:1.Find out the amount of current liabilities that should be paid.

Ans. 150000

Ques 4.

The current ratio of a company is 2:1. State giving reasons which of the following transactions would improve, reduce and not change the current ratio:
1.Payment of current liability.
2.Purchased goods on credit.
3. Sale of a computer( book value 4000) for 3000 only.
4. Sale of merchandise (goods) costing 10000 for 11,000. 

Ques 5.

Quick ratio of a company is 1:1. State with reason whether the following transactions will increase ,decrease or not change the ratio :
1. paid insurance premium in advance 10000.
2. Purchased goods on credit 8000.
3. issued fully paid equity shares of 100000.
4. issued 9% debentures of 500000 to the vendor for machinery purchased. 

Task .
Match the Answers to Assignment # 3 done

Ans. 1

Suppose current liabilities =X
current ratio 3.5:1 ,

so current assets= 3.5 X
liquid ratio 2:1,

so liquid assets= 2X
liquid assets= current assets- inventories
2X =3.5 X - 150000
= - 1.5 X= -150000

= X = - 1500000/ - 15 =100000
therefore, current liabilities= 100000 and

current assets= 3.5 × 100000 = 350000

Ans. 2
Current ratio =current assets / current liabilities

=3 /1 =CA/CL

=CA=3CL
working capital =current assets (CA) - current liabilities(CL)
400000 =3CL -CL
2 CL =400000
= CL= 400000/ 2= 200000 and

 CA = 3 × 200000=600000
therefore, liquid assets= current assets- inventory( closing) - other current assets (prepaid expenses, accrued income, advance tax )
=600000 - 200000 - ( 30000 + 15000 + 5000)= 350000
therefore, liquid ratio= liquid assets/ current liabilities

= 350000 /200000= 1.75:1

Ans. 3
Current ratio =CA/CL =450000/300000= 1.5:1
let X be paid to current liabilities to maintain ideal current ratio of 2:1.
therefore, 450000 - X/ 300000 - X = 2/1

= X =150000
Thus,150000 should be paid to current liabilities

Ans. 4

Let us assume that current assets are 50,000 and current liabilities are 25,000: thus, the current ratio is 2:1 (which is greater than 1). Now we will analyse the effect of given transactions on current ratio.

1. Payment of current liability- effect:increases or improves the ratio.
Reason: both current assets and current liabilities will decrease by the same amount.
Explanation :Assume that 10,000 of creditors is paid by cheque. This will reduce the current assets to 40,000 and current liabilities to 15000. The new ratio will be 2.67:1.( 40,000 /15000). Hence, it has proved.

2. Purchased goods on credit- effect: decrease or reduce the ratio.
Reason: both current assets and current liabilities will increase by the same amount.
Explanation: assume that goods of 10000 are purchased on credit. This will increase the current assets to 60,000 and current liabilities to 35000. The new ratio will be 1.7:1 (60000 / 35000) .Hence, it has reduced.

3.Sale of a computer ( book value: 4000) for 3000 only-
effect: increase or improve the ratio.
Reason: current assets will increase by 3000 without any change in the current liabilities.
Explanation; due to sale of a computer (a fixed asset ) the current assets will increase to 53000 without any change in the current liabilities. The new ratio will be 2.12 :1. ( 53000/ 25000 ) Hence, it has improved.

4. Sale of merchandise (goods) costing rupees 10000 for rupees 11000 - Effect: the ratio will increase or improve.
Reason:current assets will increase by 1000 without any change in the current liabilities.
Explanation: this transaction will decrease the inventories by rupees 10000 and increase cash/ debtors by 11,000 thereby increasing the current assets by rupees 1000 without any change in the current liabilities. The new ratio will be 2.04:1 ( 51,000 / 25000) . Hence, it has improved.

Ans.5

Quick Ratio = Quick assets/current liabilities = 1:1

1.Paid insurance premium in advance rupees 10000.
Effect: decrease in the ratio.
Reason: as quick asset will decrease (by the amount of prepaid insurance premium rupees 10000)with no change in current liabilities. 

2. Purchased goods on credit rupees 8000.
Effect: decrease in the ratio.
Reason: as current liabilities will increase with no change in quick assets.

(Note that increase in inventories does not cause increase in quick assets as quick assets do not include inventories.) 

3. Issued fully paid equity shares of rupees 100000.
Effect: increase in the ratio.
Reason: as quick assets will increase (by the amount of cash received on issue of equity shares rupees 100000 )with no change in current liabilities.

4. Issued 9% debentures of rupees 500000 to the vendor for machinery purchased.
Effect: No change.
Reason: As neither quick asset not current liabilities are changing. (Note that machinery purchased will increase fixed assets, not quick assets. Similarly, issue of debentures will increase long term borrowings, not current liabilities.)